LLCs: The Basics

LLCs: Learn the Basic Tax and Legal Rules of Formation and Operation

A Creature Under State Law

A limited liability company (LLC) is a business entity created under state law. Every state and the District of Columbia have LLC statutes that govern the formation and operation of LLCs.
Pennsylvania has its owns particular rules as to the legal and tax requirement of forming and operating an LLC.

Limited Liability Protection

The main advantage of an LLC is that in general its members are not personally liable for the debts of the business. Members of LLCs enjoy similar protections from personal liability for business obligations as shareholders in a corporation or limited partners in a limited partnership. Unlike the limited partnership form, which requires that there must be at least one general partner who is personally liable for all the debts of the business, no such requirement exists in an LLC.

Check The Box Rules Allow Choice As To Federal Tax Treatment

A second significant advantage is the flexibility of an LLC to choose its federal tax treatment. Under IRS’s “check-the-box” rules, an LLC can be taxed as a partnership, C corporation or S corporation for federal income tax purposes. This determination requires careful analysis as to what is the best choice for each particular client situation.

From a purest and prudence standpoint, it may be better to make an informed choice at the inception of any entity formation to simply form an S corporation or a C corporation rather than elect that an LLC have such status after you have formed an LLC.

Disregarded Entity

In addition, a single-member LLC may elect to be disregarded for federal income tax purposes or taxed as an association (corporation). If the Disregarded Entity is chosen, the individual can report the entities activity on his or her individual income tax return. This can save tax preparation fees since you need not file separate entity returns for the LLC.

However, some states and cities may require the Disregarded Entity LLC to file certain returns.

When Are LLCs Used?

LLCs are typically used for the following situations:

• entrepreneurial enterprises with small numbers of active participants
• family and other closely held businesses
• Real estate investments
• Joint ventures
• Investment partnerships.

However, almost any business that is not contemplating an initial public offering (IPO) in the near future might consider using an LLC as its entity of choice.

Conversion

Deciding to convert an LLC to a corporation later generally has no federal tax consequences. This is rarely the case when converting a corporation to an LLC. Therefore, when in doubt between forming an LLC or a corporation at the time a business in starting up, it is often wise to opt to form an LLC. As always, the possibility of a conversion in the future needs to be analyzed.

Alternatives To LLCs:

Another alternative from the tax side of planning is to utilize an S Corporation. There are sometimes advantages to using this form of entity over an LLC.  In yet certain cases, a regular corporation, sometimes called a C corporation, may be advisable. For more insight and guidance please read Choice of Business Entity For Your Business and Choice of Business Entity: Legal, Financial and Other Non-Tax Concerns

In certain situations, there may an issue as to where to incorporate.  Where an incorporate takes place in the wrong state or needs to be moved to another state please read Tax Free F Reorganizations Under Section 368(a)(1)(F) Of The Internal Revenue Code

The choice of entity question along with the related federal, state and local tax implications is one that should be discussed with an experienced tax attorney BEFORE doing anything.

Proper Documentation At Formation and Annually:

In addition, proper documentation is critical when it comes to drafting of initial organizational documents, the operating agreement and members’ (shareholders’) agreements, etc. Ongoing operations and annual compliance details should be kept in mind to insure that the entity chosen is respected as a separate legal entity so that personal assets are not put at risk due to any piercing of the corporate veil arguments.

Conclusion:

The bottom line here is that tax counsel should be part of the initial formation and ongoing operations of whatever entity is chosen to insure protection against personal liability for business operations and to maximize the various tax advantages available depending on the entity chosen.

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